Google Building For A Bigger Future

My first boss on Wall Street (and a long-time friend ever since), Archie Smith, used to say “What do you want, egg in your beer?” when faced with situations where people just didn't seem to be appreciating what they were getting. The expression made no sense to me then, nor does it now, but I do understand the frustration that fueled it. Google (Nasdaq:GOOG) is an enormous company ($14 billion in quarterly gross revenue) still growing at a 20% clip, but investors and analysts hen-peck the company for its ongoing investments into future sources of growth and the prospects for declining margins in the future. While the shares don't seem terribly cheap today, this is not a company that I'd underestimate today.

Ongoing Growth, But At An Increasing Cost
Google reported 19% growth in consolidated net revenue for the second quarter, with core Google net revenue up about 21% to over $10 billion. Web site revenue was up about 16%, with network revenue down less than 1%. Motorola continues to erode as the legacy handsets fade away, and revenue was down 65% for the quarter.

As the core search business declines as a percentage of revenue and the company continues to build up new businesses that are thus far under-scale, the margins are going down. Gross margin declined about six points this quarter, and GAAP operating income declined 4% on a five-point decline in operating margin. On an adjusted basis operating income rose about 3%, but that's really not enough to change the tone around the earnings report.

Investments Cost Money
While I do believe companies, analysts, and investors too often use the word “investment” when they mean “expense”, that's neither here nor there in the case of Google. Like Yahoo! (Nasdaq:YHOO) and eBay (Nasdaq:EBAY), Google management is spending money to build up businesses that could generate substantial future revenue. The problem is that there's no immediate cash-on-cash return for that spending and adding a bunch of sub-scale business weighs on the reported margins.

Even so, I believe Google is building up some significant “shots on goal” for future revenue growth. Although I don't think Google's e-commerce story is quite as well-defined as those of eBay or Amazon (Nasdaq:AMZN), I think the company's potential here is still underappreciated. Likewise, I believe the company's infrastructure investments in cloud will ultimately make Google a meaningful competitor to Amazon and Microsoft (Nasdaq: MSFT) down the line.

There are also other, far more speculative, opportunities underway. I'm not ready to say that Google Glass is going to displace high-end smartphones from Apple (Nasdaq: AAPL) or Samsung right away, but I think the potential is there a few years down the road, particularly if the company can strike deals with frame and lens designers to create a more stylish look and one that works with those who need prescription lenses. Likewise, I think we're a long way from self-driving cars, but the potential is so large that even only a 1% or 2% chance of success still makes it an opportunity worthy of serious consideration.

The Bottom Line
As it is today, Google is the dominant search engine and internet ad company. I don't think its far-fetched to think that Google could also be the developer of the dominant consumer OS by the end of the decade. Add in the opportunities from e-commerce and payments, and management's willingness to think big (Google Glass and the cars), and I think Google is an attractive mix of strong revenue and bold self-funded R&D.

The trick with valuing Google is considering the scale of what the company has to achieve. A long-term revenue growth forecast of 11% doesn't seem crazy (nor a free cash flow growth forecast of about 10%), but step back and appreciate that that means adding over $75 billion in revenue, or the GDP of Slovenia plus Bahrain. That's a lot of incremental revenue, even if the internet ad/search, device OS, and other markets are likely to continue growing at double-digit rates.

In any case, I believe $1,000 is a pretty good fair value target for Google, though about 15% of that is from net cash/investments on the balance sheet. While I do think investor/analyst worries about incremental margins and investment decisions could lead to more volatility, on balance I still believe these are shares worth owning.